By Caitlin Ostroff 

Italian assets slumped Wednesday as fresh political uncertainty threatened to derail reforms and pose a further setback to the troubled economy.

The yield on 10-year government bonds climbed to the highest level since August in intraday trading, before easing, on concerns that Italy's coalition government might collapse after the leader of one of the two ruling parties stepped down. Bond yields rise when prices fall. Shares in Italy's biggest banks, Intesa Sanpaolo SpA and UniCredit SpA, also fell, pulling the FTSE Italia All-Share banking index down 1.7%.

Luigi Di Maio resigned Wednesday as leader of Italy's antiestablishment 5 Star Movement ahead of regional elections this weekend in which his party was expected to slip behind its rivals.

Last September, markets cheered when the 5 Star Movement agreed to form a coalition government with former center-left Democratic Party foes, heading off the risk of a government controlled by one-time euroskeptic Matteo Salvini. Investors had become optimistic about a return to stability and hoped that the unlikely coalition would hold together, said Andreas Steno Larsen, global foreign exchange and fixed-income strategist at Nordea Markets.

"It seemed like a good idea to buy Italian bonds, given that everything was stable," Mr. Steno Larsen said. "The risk of a new election is underpriced by the market."

Following the initial reports of Mr. Di Maio's impending resignation late Tuesday, Italian 10-year government bond yields climbed to 1.468% before easing to 1.35% Wednesday, according to Tradeweb.

To close observers of Italian politics, Mr. Di Maio's resignation was no surprise, and the appearance of stability last year was misleading. Italian politics have been in flux for years, with support for established parties plunging and a series of political insurgents seeking to capitalize on widespread voter discontent about economic stagnation, political corruption and immigration.

Italian bonds remain among the few in Europe offering attractive yields to investors, after central banks have in recent years pushed key policy rates below zero. Ten-year bunds from Germany, Europe's largest economy, offer a yield of minus-0.298%. The yield on the 10-year U.S. Treasury note was unchanged Wednesday at 1.768%, while the WSJ Dollar Index inched down 0.1% to 90.40.

The "sizable premium" offered by Italian bonds reflects the higher political uncertainty, Goldman Sachs said in a note to clients Tuesday, before reports of Mr. Di Maio's expected resignation surfaced.

Popular support for the 5 Star Movement has tanked since the party won a third of the vote in Italy's 2018 elections, piling pressure on Mr. Di Maio. His resignation is unlikely to directly affect the government's longevity but is a symptom of the 5 Star Movement's steady erosion. If a snap national election were to be held, opinion polls suggest the anti-immigration League party, led by Mr. Salvini, would probably win.

Mr. Di Maio's resignation could trigger snap elections within the next six months, said Florian Hense, economist at Berenberg Bank. "Investors don't like uncertainty, but that's very much the short-term response," he said. "The issue with Italy is that it's a time bomb. If there's a global recession in the next two-three years, Italy would be a prime candidate for a debt crisis."

Mr. Salvini's past skepticism about the euro and the European Union's fiscal rules makes many investors nervous about the potential for conflict between Rome and EU authorities if he takes power.

Mr. Steno Larsen said he isn't worried about moves in the bond market spilling over to the banking sector in a repeat of the crisis in 2018, when political instability in Italy fueled fears that the country could leave the eurozone.

--Marcus Walker and Anna Isaac contributed to this article.

Write to Caitlin Ostroff at caitlin.ostroff@wsj.com

(END) Dow Jones Newswires

January 22, 2020 19:53 ET (00:53 GMT)

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